- POST is up over 70% over the past year.
- Acquisitions have rejuvenated the venerable food giant.
- Amortization of intangibles unfairly weigh down POST.
- Returns on capital will improve, but General Mills may be a healthier choice.
This article originally appeared on Seeking Alpha on May 27, 2016
Post Holdings (NYSE:POST) may be a 119 year-old company, but its recent transformation has been profound. In 2012, Post spun off the private label giant Ralcorp. Subsequently, ConAgra (CAG) nearly ruined itself through an acquisition of the hapless private label food manufacturer. Post looks incredibly wise in hindsight.
Impressive quarterly results seem to justify the 73% increase over the past year to $74 per share. Sporting a market cap of $4.73 billion and sales of $4.6 billion in 2015, the Post story has been based on a flurry of acquisitions.
POST acquired Mom Brands in May of 2015 for $1.2 billion. Other FY 2015 purchases included Power Bar ($150 million) and American Blanching Company ($128 million). The firm was even busier in 2014: POST acquired pasta maker Dakota Growers for $370 million, protein bars and supplement maker Dymatize ($380 million), and peanut processor Golden Boy (CAD $320 million). But the biggest chunk of business that Post swallowed was Michael Foods for $2.45 billion. Michael Foods has offerings from egg and potato products to dairy brands.
Post management is very enthusiastic about this rejuvenated company despite its declining dry cereals sales. But does POST have the energy to justify its $74 price? For once, this author is landing in bullish territory. I believe the stock is worth in excess of $90 per share.
Attention shoppers: discount in aisle four
**POST return on capital is based on 2016 estimates. GIS and K are presented as 2015 results.
One may argue that the comparison between these cereal brands – turned – food giants is slightly misleading. After all, Kellogg and General Mills are much larger enterprises, $26 billion and $37.2 billion in market capitalization, respectively. Still, they offer decent benchmarks for relative value.
General Mills appears to be the best of the bunch and the author will be digging deeper into the GIS filings for proof of its relative investment merit in a future article. GIS has low debt, a healthy dividend yield, a reasonable price to EBITDA ratio, and a hefty 17.5% return on capital (pre-tax and excluding a one-time non-cash charge). Kellogg seems a little overpriced by comparison.
POST only trades at 1.6 times book value and 7.4 times EBITDA. It had a paltry 2.5% return on capital in 2015, but should exceed 9% in 2016. This is nowhere near as strong as GIS, but it’s a very positive move in the right direction. If you apply a 10 multiple to 2016 forecast EBITDA, the value exceeds $140.
If you’re reaching for your “buy” button right now expecting to double your money, hold on. There are reasons why a value below $100 is much more realistic.
POST has a heavy debt load as a result of the acquisition spree. POST also lags in its brand investments. Capital expenditures must rise significantly in the future. Meanwhile, a consistent level of performance remains to be proven. While 2016 looks like it will be a strong year with over 9% return on capital, 2.5% was the number posted in 2015. The jury, therefore, may still be out.
I also raise the caution flag about POST’s ability to match the performance of its peers due to the daunting task of integrating so many brands and facilities under one umbrella. The decision to unload RalCorp must still draw smug smiles of schadenfreude around the Post water cooler. Yet, as so many poorly executed acquisitions have shown, caveat emptor always applies. For example, I note that Michael Foods was purchased for $2.45 billion from Thomas H. Lee Partners. Private equity firms are rarely known for selling assets unless full value can be harvested. There is a chance that POST has overpaid.
So you’ve read the reasons why I temper my enthusiasm for POST. Let’s now look at the reasonable case for more upside.
The tangibility of intangibles
Post has some accounting hurdles that mask the company’s strengths. They are required to amortize a large amount of intangible assets (customer lists, trademarks, etc.) due to their massive acquisitions. These charges are non-cash items but directly hit earnings on a GAAP basis. They will also persist for many years to come. In fact, Post goes out of its way to highlight these charges as a separate line item on the income statement. In 2015, these charges totaled over $141 million. This was enough to drag corporate level operating margins down from 7.62% to 4.58%.
The treatment of intangible asset amortization at Post does seem to be an unfair burden when compared to K and GIS. These food giants also have massive levels of intangible assets on their balance sheet, yet unlike Post, they are not required to amortize the vast majority of this accounting item. As the chart below indicates, K and GIS are not required to amortize nearly 90% of intangible assets. Meanwhile, the polar opposite is required at POST.
Is Post being treated unfairly? Yes and no. Yes, operating income is actually much higher than accountants would lead you to believe. Unfortunately, there are no free lunches (or breakfasts) and the lack of investment shows up in the cash flow statement. In other words, Post may want you to give them the benefit of the doubt on their operating income, but their lack of brand investment tells a different story.
Intangibles may sound fuzzy, but they are very real drivers of value. In 2013, Professor Aswath Damodaran calculated Coca-Cola’s (NYSE:KO) brand equity was worth somewhere between $120 and $150 billion that was not on its balance sheet.
Unlike Coke, who largely built its brand through the compound efforts of decades of marketing and advertising, Post has essentially “bought” these brand assets. Yes, it’s unfortunate that Post has to charge off these intangibles. But they also need to be replacing them. Brands are nebulous concepts, but they are critical to consumer purchases. Unlike 2005, Power Bar no longer sits alone on the grocer’s shelf. It competes with Clif, Kind and every other protein-packed nutrition bar in the aisle. Post will have to spend millions to repackage and re-market this tired brand. As for their core breakfast cereals, when is the last time you were inspired to buy a box of Grape Nuts?
Compared with Kellogg and General Mills, investment and advertising are sorely behind schedule at Post. As the table above shows, advertising is much lower as a percentage of sales. Net capital expenditures are also much lower. A corporation cannot sustain growth if it doesn’t eventually replace depreciating assets at a comparable rate. Ultimately, the need for investments at Post will depress future cash flows.
Discounted cash flows indicate a $90 value
Let’s review. Returns on capital are going to start exceeding the cost of capital in a very strong manner during 2016. While they won’t exceed comparable food makers, they will create value. The strong performance is buried under the unfortunate accounting treatment of amortization charges on intangible assets. POST is relatively inexpensive but doesn’t deserve the same multiples as its peers until it shows consistent results and shows it can support its debt burden.
Presented below is my discounted cash flow analysis with a price of $90 per share. I indicate some consistent growth in the +5% arena, corporate-level operating margins slightly above 10% and a low weighted-average cost of capital of 4.54%. POST won’t pay much tax in the next few years due to some net operating loss carry-forwards.
This is a company with a 6.75% cost of debt that is about 49% leveraged. I applied Kellogg’s beta of .47 rather than the .21 shown on several finance sites. I gave Post the benefit of the doubt and showed depreciation and amortization add-backs in excess of capex for many years. As the years progress, I show depreciation and capex converging. Assets, both tangible and intangible, must still be replaced in order for growth to occur.
(click to enlarge)
A word about Pensions
The bullish argument for POST also includes the idea that the relatively small size of the business allows it to be more “nimble.” I’m not sure how nimble a 119-year-old company can be, but I take that compliment at face value.
POST is certainly not burdened by pension obligations. The big boys have big liabilities. Kellogg has $5.36 billion in pension obligations and a $732 million shortfall. GIS has $6.25 billion due with a shortfall of $493.6 million. POST has pension obligations less than $60 million.
Both K and GIS further obfuscate their hidden obligations through ridiculous pension investment return assumptions. Like most governments in the US, K and GIS are delusional in their projection that they can achieve 8.3% to 8.5% returns on plan assets in a world of sub-2% Treasuries. Taxpayers and corporate boards need to ask tougher questions and brace for future payments that are well beyond the scope of forecasts.
What does Post predict? 5.72%